Sunday, September 23, 2012

Brighter Days Ahead for China?

Earlier this week, G.Bin Zhao, Executive Editor of China's Economy & Policy, wrote an interesting article which was published on South China Morning Post, "Brighter days ahead for China's economy". This article can be downloaded for free and was posted on CEP's website:

The Chinese economy is in decline, the stock market remains in a downturn, the property market faces strict macro controls, and the purchasing managers' index for August has fallen to a new nine-month low, all of which is causing widespread concern. Many people at home and abroad have started to worry about China's economic prospects. For example, there is heated debate over whether China will suffer a "hard" or "soft" landing.

I would echo the comments of Stephen Roach, the former chairman of Morgan Stanley Asia, who wrote recently: "These worries are overblown. Yes, China's economy has slowed. But the slowdown has been contained, and will likely remain so for the foreseeable future."I can't predict when the economy will rebound, but perhaps it is time for analysts to look at the longer term. Where will China stand in 20 years?

First, let's examine the prediction that its gross domestic product will become the largest in the world within a decade, and its economy will continue to improve over the next two decades. The Economist expects Chinese GDP to surpass America's by 2018, and even if China's growth rate were to drop to 5 per cent, this transition would only be delayed until 2021. Therefore, there is little need to worry about current GDP growth falling to 8 per cent. Other forecasts of when the transition will happen include 2016 (the International Monetary Fund) and 2020 (the Chinese Academy of Social Sciences). However, even if China's total economy exceeds that of the US, it will not mean China is stronger economically - it is harder to predict when China's comprehensive national strength will surpass that of the US.

Second, the renminbi is forecast to become freely convertible within 10 years and possibly will be competing with the US dollar in two decades. In recent discussions, it was thought this first step could be realised in five years. I believe it will probably happen by 2020, or when Chinese GDP becomes the largest in the world. The renminbi will surpass the euro and the yen to become the second-strongest global currency within three to five years after it becomes freely convertible. But there are too many uncertainties to predict whether it can challenge the dollar as the international reserve currency in the next two decades.

Third, it is said that Hong Kong is likely to exceed New York as a global financial centre within 20 years. As China's economy continues to grow and develop, the realisation of the first two predictions will provide a great boost for Hong Kong, and it is expected to gradually become the dominant global financial centre. To prepare for this, Hong Kong needs to deepen its co-operation with Guangdong, promoting Shenzhen as Hong Kong's "backyard", and, within five to 10 years, cancelling the restrictions on mainland residents who want to travel to Hong Kong, or, if necessary, retain only the work permit system.

It also needs to continuously enhance the level of financial co-operation with the mainland. For example, renminbi- denominated stocks need to be issued in Hong Kong as soon as possible.

Fourth, some predict that Chinese enterprises will make up more than half of the Fortune Global 500 companies in two decades, and China will be a global manufacturing power. This year, there are 73 Chinese companies (79 if Taiwanese companies are included) on the list, a significant increase from only 11 a decade ago. Unfortunately, many of these Chinese enterprises have only an advantage of scale and are not real industry leaders; there are not many world-renowned brands within this select group. However, quantitative change can lead to qualitative change; these enterprises can be transformed into truly leading multinational companies within two decades.

Fifth, China is expected to make significant progress in the field of science, technology and education, and the University of Hong Kong is likely to be ranked among the top 10 in the world within two decades. According to a study by the science and technology think tank Battelle, China currently accounts for about 15 per cent of the total share of global research and development spending, and it will surpass the US spending within a decade. In addition, according to figures from the State Intellectual Property Office of China, total patent applications were more than those of Japan and the US in 2011.

In 20 years, China will almost certainly have made significant progress in science, technology and education. Research institutions and universities are the cradle for scientific and technological development. Hence, the international stature of Chinese universities should rise: The University of Hong Kong can surely rank among the top 10 in the world, while Beijing's Peking and Tsinghua universities are likely to be among the top 20.

Finally, China can narrow the gap with the US in the aerospace industry within two decades.

Without strong scientific, technological and industrial strength, progress in this industry will not be possible. It also needs strong support from communications, electronics, equipment, materials, chemical, metallurgy and other industries. Although China's achievements in the aerospace industry have been impressive in recent years, experts say it is still at least 30 years behind the US.

This is changing, and along with the updating and upgrading of related industries, as well as continuous national investment, China will become a space power second only to the US in 20 years. China may not be able to surpass the US, but it will surely be getting closer.

Thus, there is every reason to be optimistic about China's economic prospects over the next two decades.

Having said this, Mr. Zhao is right, the pervasive gloom today over the Chinese economy is obscuring the positive longer-term trends that suggest the nation is on track to become a powerhouse in 20 years. I happen to think it's already a powerhouse but it has many reforms ahead if it wants to surpass the US in 20 years.

If China isn't in as bad shape as many think, institutional investors will need to reassess their asset allocation and refocus their attention on assets leveraged to Chinese growth. I think the euphoria in cyclicals will continue and caution investors to pay attention here as volatility in cyclicals might be a precursor to a major melt-up in cyclical stocks that got killed because of euro woes and exaggerated fears of a hard landing in China.

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I am an independent senior economist and pension and investment analyst with years of experience working on the buy and sell-side. I have researched and invested in traditional and alternative asset classes at two of the largest public pension funds in Canada, the Caisse de dépôt et placement du Québec (Caisse) and the Public Sector Pension Investment Board (PSP Investments). I've also consulted the Treasury Board Secretariat of Canada on the governance of the Federal Public Service Pension Plan (2007) and been invited to speak at the Standing Committee on Finance (2009) and the Senate Standing Committee on Banking, Commerce and Trade (2010) to discuss Canada's pension system. You can follow my blog posts on your Bloomberg terminal and track me on Twitter (@PensionPulse) where I post many links to pension and investment articles as well as my market thoughts and other articles of interest.

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